Josh Kaplan & Steven Schoenfeld: BlueStar Israel Equity Market Outlook–Oct. 2012 in Review & Nov. 2012 Outlook
By Josh Kaplan and Steven Schoenfeld of BlueStar Global Investors LLC–November 8, 2012
This monthly column produced by BlueStar Global Investors discusses Israeli equities traded worldwide. The relevant benchmark for our review is the BlueStar Israel Global Index (“BIGI” BLS:IND on Bloomberg), which we believe represents the opportunity set of Israeli equity investments better than other benchmarks (such as the TA-25/TA-100 and MSCI Israel).
It is becoming widely known that Israel has one of the most resilient economies in the world and that its technology sector plays an integral part in the global technological revolution. Fewer are aware of the global footprint of Israel’s companies in other sectors, and fewer still are aware of how to make their knowledge of the Israeli economy actionable. This column helps investors gain insight into the macro forces (including the geopolitical environment under which Israel’s economy operates) and the individual company investment opportunities that have contributed to global Israeli equities’ outperformance of U.S. equities by nearly 1,500% over the past two decades.
One key reason why the BlueStar Israel Global Index (BIGI) is more relevant to North American investors than the TA-100 or MSCI Israel indexes is that BIGI includes Israeli companies that are listed on exchanges outside of Israel, including NYSE and Nasdaq, thus providing investors with a benchmark that is balanced across key sectors. (For example, BIGI has a 31% tech weighting, while MSCI has a 13.5% tech weighting). In addition, BIGI caps the largest constituent by weight at 12.5% to attenuate the impact of any single stock on the index.
In this column, we discuss BIGI’s performance over the previous month, including the largest percentage gainers and losers, sector performance, technical analysis, and key industry-specific and policy developments. We also touch upon relevant domestic and international economic and geopolitical events. Readers are encouraged to use the trends and ideas presented in this column and take the time to research specific investment opportunities further.
Building a Solid Foundation
In October, Israeli global equities continued to build on September’s rebound. Despite the slight lowering of 2013 GDP growth rate forecasts, investors should be encouraged by the resiliency of Israel’s economy and prudence of its economic leadership. Domestic-oriented companies once again led the Israeli Global equity market this month while the stock prices of Israel’s technology companies have reflected slower global economic growth. The major developments in October were a surprise interest rate cut alongside measures taken to cool the housing market; meetings between executives of global oil and gas majors and Israeli officials; and more visibility on the stability and security that the emerging energy industry will bring. Additionally, the developments of September and August (credit rating affirmations, confirmation of Israel’s financial system stability, and geopolitical developments) continued in October, and will continue into the foreseeable future, to provide solid support for Israel’s economy and global Israeli equities. A two-month rally in global Israeli equities is not insignificant, but there could be obstacles ahead due to: continued deterioration of the global economy and the European debt crisis; the looming US “fiscal cliff”; early Prime Ministerial elections; potentially lower-than-expected yield of gas and oil drilling; further and stronger intervention in the real estate and mortgage markets; socioeconomic-related unrest; and potential geopolitical instability.
BIGI (BlueStar Israel Global Index) Performance Versus the TA-100 and S&P 500 Indices Since Jan 1 2010
Israeli equities, as measured by the BlueStar Israel Global Index (BLS:IND), gained 2.83% in October. Israeli equities outpaced developed and emerging market equities and global Israeli equities outperformed the S&P 500 by 4.81%. The divergence between Israeli and U.S. equities (with U.S. equities outperforming) over the past twelve months or so represents the largest performance differential between the two markets in recent years. We attribute this mostly to overblown fears of geopolitical risks in the Israeli market. As we have seen repeatedly, investors in Israeli markets typically overreact to geopolitical risks and long-term investors are rewarded with strong outperformance once fear-based selling subsides. [See the chart at the end of the column on this subject]. We are not surprised to see Israeli equities playing catch-up based on strong economic fundamentals, a stable Shekel, and geopolitical risks pushed forward.
The broad Israeli Global Equity universe – which includes companies listed in Tel Aviv, the U.S., and elsewhere – provides investors with exposure to Israel’s economy as well as exposure to several vibrant and globally-oriented economic sectors.
October 2012 Sector Performance and Winners and Losers
In October, the Financials sector led global Israeli equities higher, gaining 2.14%. Leadership within the Financials was mixed between subsectors but Discount Investment Corp (84.08%), Harel Insurance and Investments (25.02%), Clal Insurance Investments (24.12%), and Israel Discount Bank (18.14%) were among the top performers. The surge in Financials stocks was broad-based as half of the 21 Financials stocks within the BlueStar Israel Global Index had double digit gains and only three experienced stock price declines. This sector’s October performance is a continuation of last month’s rise, which came on the heels of Israel’s sovereign debt rating affirmation and stable outlook despite increased restrictions on fees charged to banks’ customers. There is also increased awareness among the investment community that some of the largest banks ought to be more profitable, and banks are planning to streamline their operations in order to operate more efficiently. Bank Leumi has committed to reducing its workforce by 8% by 2014 and Bank Hapoalim is reducing its headquarters staff by 20-30%, which equates to 400-650 people.
The major news for the industry and economy came towards the end of the month. The Bank of Israel surprised the market and cut its November policy interest rate by 25 bps to 2.00%, citing low inflationary pressure and the need to support economic activity. On the other hand, the Bank is taking steps to cool down the housing market and prevent a real estate price bubble. [These topics will be discussed in the Economic, Fiscal and Market Outlook section towards the end of the column.] It is apparent that at least some sort of housing market restrictions were baked into Financials’ stock prices as the sector held onto October gains after the report. Mizrahi Tefahot Bank (the top mortgage bank in Israel), which has been one of the top performing companies in the sector over the last couple of months pulled back more sharply than other large banks on the news. Last month we wrote that we would hold an overweight position in the Financials sector. We expect the Financials to continue to gain moving into the last months of the year, perhaps at a slower pace. The operational adjustments discussed above and an undervalued domestic banking sector relative to international peers is encouraging.
Basic Materials stocks were once again among the best performing stocks within the BlueStar Israel Global Index. All four components of the sector gained, led by Koor Industries (36.44%) and followed by Frutarom (9.40%), Israel Corp (7.03%), and Israel Chemicals (3.21%). Israel Corp owns a majority share of Israel Chemicals. It was announced late in the month that Potash, a Canadian company and the largest supplier of Potash in the world, is seeking a merger with Israel Chemicals, likely to gain greater exposure to Asian markets. Frutarom is a great global Israeli growth company that creates and markets high quality flavors and fine ingredients for customers in the food, beverage, fragrance, and pharmaceuticals industries. Frutarom has employed a successful synthetic growth strategy over the years to reach markets all over the world, from Western and Eastern Europe to Asia and South America.
Like the Financials, shares of companies in the Oil & Gas industry continued to build on previous months’ gains, rising 0.9% in October. After the Tzemach Committee announced plans to allow companies to export between 50% and 75% of natural gas reserves, major license holders and global oil and gas majors began the process of deciding on the most suitable major to assist in developing Israel’s energy export market in terms of operational know-how and financial strength. Maybe Russia’s Gazprom was the initial front runner but Australia’s Woodside energy entered a competitive bid for 30% of the Leviathan Partners’ gas licenses. Woodside Energy’s CEO and top executives met with Prime Minister Netanyahu to discuss why Woodside would be the best fit for Israel’s partner on this, citing namely their ability to market to South East Asia where competition is less fierce than in Europe.
Though the recommendation of the Tzemach Committee opened the gates to allow such talks, Israel’s ability to export natural gas is still contingent upon the continued finding of sufficient reserves. Last month, the partners involved with the Myra 1 well, once thought to be a potentially significant well, announced that there was no gas to be recovered there. Nonetheless, it has become abundantly clear that Israel’s energy market is well on its way to self-sufficiency. Several natural gas supply deals (highlighted below) to energy producers and major industrial corporations, are being announced as are pipeline and gas terminal plans. We expect that domestically produced natural gas will begin affecting Israel’s current account and CPI as early as the second quarter of 2013. The key developments and deals struck in October were:
– Shishmom reservoir has a best estimate of natural gas at 0.55 trillion cubic feet
– Tamar Partners stated: “The largest infrastructure project in Israeli history is moving ahead on schedule.” The Tamar field’s production platform is on its way to Israel and production is set to begin in March 2013
– Shikun and Binui is borrowing NIS 300 million to expand its Ashdod power station and convert it to natural gas
– Noble energy raising its probability of success in finding oil at Leviathan wells to 25%: potentially 3 billion barrels of oil
– Tamar Partners signed a 16-year gas supply deal with Dorad Energy worth $4 billion; total outstanding supply contracts to date are worth over $35 billion
– Givot Olam rented a 300,000 barrel oil storage tank for its on-shore oil well near Rosh Ha’Ayin
– OPC’s power station at Mishor Rotem will come on line in 2013
– Israel Chemicals power station will come on line in 2014
– LNG buoy near Hadera to begin operations by the end of 2012
– Energy Ministry proposed having two onshore gas terminal sites, one in the North and one in the South
– Israel National Gas Pipelines to hold NIS 2 billion IPO by mid 2013
Last month we said that we would hold an overweight position in the Israeli Oil & Gas sector despite its somewhat speculative stage, and we continue to hold that view. The key risks of investing in this sector are that drilling will not yield best estimate reserves of natural gas and that, if it doesn’t, the government ministries in charge will reduce the allowance of exports. Also, as goes for investing in any country’s oil or gas companies, there is a chance of spill or leak that would result in legal-related expenses and loss of marketable resources. Despite these risks, we would overweight this sector as a long-term investment (adding to our overweight on pull-backs and reducing our overweight on surges) as it is clear this industry will become a major component of Israel’s economy.
Profiles of Key Company Movers in October
Discount Investment Corp (DISI:TASE) was the top performing global Israeli equity for the second month in a row, gaining 84.08%. The company is one of the largest holding companies in Israel with both domestic and export-oriented holdings in various industries. The top domestic holdings are: Cellcom, the largest cellular operator in Israel; Shufersal, the largest grocery store chain in Israel; and Property and Building Corporation, one of the largest real-estate groups in Israel. International holdings include: Makhteshim Agan (via its holding of Koor Industries), which is a global leader in manufacturing generic agrochemical products; Elron, a high-tech investment company; Given Imaging, a medical device company which created the PillCam; and Maariv Holdings, a player in the media and publishing industry.
Koor Industries (KOR:TASE) , a subsidiary of Discount Investment Corp, gained 36.44% in October, placing it among the top performing global Israeli equities. Koor Industries is a holding company itself. Its major holdings are Makhteshim Agan (a leading manufacturer of agro-chemical products) and Credit Suisse Group (one of the world’s largest banking groups). Koor Industries is expected to report a profit of NIS 355 million on its investment in Credit Suisse in Q3 2012, as the Bank’s stock rose 14.6% over that period.
Given Imaging (GIVN:NASDAQ, GIVN:TASE) , also a subsidiary of Discount Investment Corp, is now in acquisition talks with potential buyers after completing its own acquisition of SmartPill. SmartPill is a strategic fit for Given Imaging and adds to its product mix. Also adding to Given’s attractiveness as a takeover target is that the company has filed for approval of the PillCam Colon 2 in Japan, a market with tremendous potential for its products. Fujinon, a unit of Fujifilm Holdings, is in the most advanced acquisition talks with Given Imaging. The rumored deal proposed would give Given Imaging a company value of $750 million; its current market cap is approximately $560 million.
Last month, two of the BlueStar Israel Global Index’s top-ten holdings, Verifone Systems (PAY:NYSE) and Mellanox Technologies (MLNX:NASDAQ, MLNX:TASE), were among the top three declining global Israeli equities. In October, Mellanox was once again one of the biggest decliners amongst BIGI constituents. After reporting record revenue and earnings, but lower guidance, Mellanox shares plunged nearly 30%. We are still bullish, though now less cautiously, on shares of Mellanox Technologies as a long term investment prospect. As we state in the concluding paragraph, we would be cautious and consider using hedging strategies on Israeli global equities trading on US exchanges given macro headwinds there.
VeriFone Systems is a global leader in secure electronic payment software and systems. Analysts and traders have not been optimistic about VeriFone’s ability to fulfill the growth potential that the once-lofty stock price suggested in light of new smaller competitors and developments in the product arena—namely payments systems that run through mobile devices such as iPads and Tablets. The company’s CEO is confident, however, that VeriFone will continue to provide the leading players in all the industries it serves with all-in-one state-of-the art payments solutions. We believe the upside in VeriFone Systems will be somewhat limited until there is more clarity as to how much market share new entrants will actually be able to achieve. However, technically, it appears that VeriFone’s stock has formed a reverse head-and-shoulders pattern with the “shoulders” at the long-term support level of $30/share. Again, caution should be used in investing in US-listed shares given macro headwinds there.
Market Trends – Technical Analysis and Market Fundamentals
Technical Analysis of the Israeli Market
The technical picture for Israeli stocks, as measured by the broad-based BlueStar Israel Global Index (BIGI), became more constructive in September and breached important trend lines in its move upward in October. BIGI repeatedly tested key support during Q2 and Q3 2012 around the index level of 195/200 (see solid red support line on two-year chart). In October, BIGI broke through the black downtrend line which begins at the mid-2011 highs. After this breakthrough – a very bullish development – the index hit resistance near the 218-220 levels. It then retreated to the 211-212 level. A sustained breakout above the 218/220 index level is needed to confidently reassert a bullish trend. In this case, initial resistance is expected at the index level of 230-235, represented by the solid green line. We consider the 200/205 level as new support for BIGI. If markets pull back, we will watch for a test of the black downtrend line that was breached in October (which also coincides with the two-year support level of 200 represented by the dotted red line on the two year chart).
The longer-term outlook for Israeli equities is now constructively neutral, and will become bullish only if the index breaks back into — and ideally through — the channel connecting the 2008/2009 lows, as illustrated in the BIGI five-year chart, which spans the entire 2008-2009 global financial crisis. This corresponds with the 225/230 level mentioned above. BIGI did breach the lower band of the channel but did not break through it in October.
To review the long-term analysis of the patterns on the five-year chart, BIGI, like other Israeli indexes, bottomed in late October 2008 and again in early March 2009, followed by a powerful rally into spring 2010. It found solid support during late 2011 at the key technical level of 195. This corresponds with an uptrend beginning with the early 2009 bottom (solid red uptrend line), and the horizontal support zone dating back to autumn 2007 (solid red line), also at approximately the 195 BIGI level. As noted above, this level was repeatedly probed in June and July 2012, and again later in the summer, and by the end of last month and Q3 has confirmed the support at this level.
If BIGI does enter into the aforementioned channel, a rally to strong resistance is projected to be at 239/240, as highlighted by the solid green line. If this resistance is broken, we see the projected upside potential of the index to be at the 300 level by early-mid 2013, though most likely following a consolidation at the 2011 high of 275.
From a risk management perspective, the revised stop-loss at the 195/197 level articulated in our September and October Outlooks remains valid, but those with a shorter-term perspective should keep their stop-loss at 200/205 in BIGI for the remainder of autumn and into early Winter. If these levels are breached and confirmed with a weekly close of BIGI below 195, the longer-term outlook will shift dramatically, and any rallies should be sold. A breach of 195/192 will increase the likelihood that the spring 2011 peaks represent the ‘head’ of a massive ‘head and shoulders’ pattern which would project a major decline to around 135, just above the autumn 2008/March 2009 lows. However, if these newly-adjusted higher stop-loss levels hold, and a rally can lift BIGI decisively above the 220 level, there is hope that this major multi-year support level will have held, and can potentially form a base for a sustained rally. If the latter scenario develops, we would expect medium and long-term targets as high as the 275 and 300 levels, respectively.
As The Ministry of Finance studies the effects of the January 2012 5% increase in the capital gains tax on declining trading volumes, we continue to monitor portfolio flows in terms of both net international investment in capital markets and asset allocation among the local markets. One strategy for reviving trading volumes which we’ve discussed in prior months would be to include Israel in the MSCI Europe index. This would force index and portfolio managers to trade Israeli shares to gain the proper exposure to Israeli stocks.
Non-Israelis invested a net $160 million in Tel Aviv-listed shares in August, a nearly 38% sequential monthly drop. On the other hand, non residents sold a net $90 million in government bonds and $10 million in short-term treasury notes. Israeli’s investment in foreign-listed shares totaled $780 million in August, mostly by institutions. The business sector, though, was a net seller of $30 million of foreign-listed shares.
Local Israeli mutual fund flows reversed a five-month net withdrawal streak in October. An undercurrent of this reversal is that investors were net sellers of government shekel bond mutual funds yet net buyers of equity mutual funds, suggesting that a tendency towards riskier assets may be emerging. We should not discount the role that the Bank of Israel’s surprise interest rate cut played in this shift despite the fact that the decision was announced towards the end of the month. Mutual funds in general raised a net NIS 1.9 billion in October, including NIS 520 million in redemptions of money market mutual funds and NIS 300 million of government bond mutual funds.
In early November, the Knesset passed the “trapped profits bill” to allow companies to use profits accumulated in Israel for foreign investment so long as they pay a (reduced) tax on these profits and 50% of these profits are used to invest in one of the following: productive assets at plants, Research and Development, or hiring new employees. The ministry hopes this bill will increase tax revenues for the state and open up NIS120 billion for investment in Israel and abroad by Israeli companies. This is a bullish development for the investment component of GDP growth (which has been the cause of most of the downward revisions to Israel’s 2013 GDP forecast) as well as for the Government budget deficit.
Lastly, Israel reached two international economic-related agreements in October: 1- the Israel Securities Authority joined the International Organization of Securities Commissions in the European Regional Committee; and 2- the European parliament approved a technical agreement that makes it easier for Israeli pharmaceutical companies to market their products in Europe.
The main risk factors for global Israeli equities continue to be the European sovereign debt crisis and weak economic growth globally. Other risk factors for global Israeli equities include regulation and policy issues; ongoing corporate debt restructurings; and rising inflation expectations.
After a brief lull in the rocket attacks on Israel’s Southern districts in September, rocket fire and return fire by the Israeli Air force resumed in October. The IDF continues to prepare for imminent confrontations on multiple fronts possibly resulting from the spill-over of the Syrian crisis over Israel’s borders. Early in November, three Syrian tanks were spotted crossing into the demilitarized zone between the Israeli and Syrian border. Also, the stand-off between Israel and Western powers and the Iranian regime made no progress in October. The Iranian currency continues to plunge and inflation remains in double-digits; protesters began taking to the streets in Tehran back in September. Also in September, we learned from Prime Minister Netanyahu in his address to the UN General Assembly what his “red line” is and that any Israeli strike against Iran will not occur until early-mid 2013. We believe these developments regarding Iran have led to the release of much of the geopolitical pressure on global Israeli equities.
Stanley Fisher, governor of the Bank of Israel, said the following about the geopolitical effect on business and the economy in Israel: “There is a certain effect felt in the stock market in a particular way, but my feeling is that if there is an impact, then it is small.”
Economic and Fiscal Outlook
October’s Israeli GDP forecast updates are as follows: IMF forecasts 2012 growth of 2.9% and 2013 growth of 3.2%; Central Bureau of Statistics forecasts 2012 growth of 3.5%; Merrill Lynch forecasts 2013 growth of 2.9%; Manufacturers Association of Israel forecasts 2012 growth of 3.5% and 2013 growth of 2.7%.
Other economic forecasts include: IMF officials see gross public debt to GDP ratio lowering to 73% in 2013, 72% in 2014 and 67% within the next five years; The Central Bureau of Statistics sees per capita GDP growth slowing to 0.9% in 2013 from 1.7% in 2012; The Central Bureau of Statistics sees exports growing by 5.6% in 2012 after growing 4.1% in 2011 and imports growing by 3% in 2012.
The Bank of Israel’s monetary committee lowered the interest rate for November by 25 bps to 2.00% in light of slower global economic growth and lowered domestic economic growth forecasts and flat CPI for September. Though the interest rate cut was surprising to many, inflation pressure has been due mostly to energy, food, and housing costs, all offset by lowered prices in other areas. As discussed, major natural gas deliveries will begin in Q1 2013 and measures are being taken by the Ministry of Finance to increase competition for food products, thus lowering prices to address inflationary concerns in the energy and food components. Though the housing market is worrisome, we like that BOI takes preventative not reactionary measures. Many analysts doubt the effectiveness of the measures taken in October to cool the housing market (discussed below). We’d like to give the initial measures some time to work before making a similar judgment: there is a major supply-demand imbalance and measures have been taken both to incentivize building and diminish excessive or speculative demand.
The Bank of Israel’s bank regulator finally conceded to the overheating housing market and continuously rising housing price expectations. The bank supervisor published a draft directive limiting the loan-to-value ratio in housing loans beginning November 1st. The directive differentiates between investors, those borrowing for home-upgrades, and first time home buyers, assigning the lowest maximum loan-to-value ratio for the investor category at 50%. Members of the investor category are non-residents and those purchasing a second home. The directive is meant to restore proper risk-reward balance in housing loans and to have banks’ balance sheets properly reflect the risk of their credit portfolios.
Given sector-driven, geopolitical, and macroeconomic developments that are on balance positive, combined with our technical analysis view of the global Israeli equity market, we remain bullish on global Israeli equities in the medium-long term. In the near-term (next month or two) we are a bit cautious until the US elections have passed and the so-called fiscal cliff has been avoided. We see a positive risk-reward relationship despite the ever-present geopolitical currents in the Middle East. From a sector perspective, we would reduce our overweight in the financials sector and maintain our overweight in the oil and gas sector (though the oil and gas sector is still in somewhat of a speculative phase). We are paying close attention to global business cycles and economic developments in Europe and the U.S. to judge if and when we would increase exposure to Israeli technology companies. Given October’s correction in Israel’s technology sector, we would begin rebuilding to an equal-weight position in this sector, buying favored stocks on pull backs, but extra caution should be given to US-listed technology companies until the fiscal cliff is avoided and clarity on capital gains and dividend tax rates is given.
Amidst significant geopolitical and global economic challenges, Israel’s economy continues to outperform its OECD peers, as well as many Emerging Markets. Its equity market has, unsurprisingly, been buffeted by Europe’s economic crisis and the global downtrend in stock markets. However, the long-term attraction of Israeli stocks remains intact, and the global nature of Israel’s equity market makes it naturally diversified vis-à-vis regional tensions in the Mideast. We continue to believe that a broad selection of Israeli stocks provides exposure to both global and domestic economic growth. Such broad-based Israeli equity exposure potentially offers ‘the best of both worlds’ — Developed Market stability, and the demographics and growth potential of an Emerging Market. In addition, Israel’s robust high-tech sector continues to drive scientific, info-tech, agricultural and defense-tech advancement around the world.
Editor’s Note: Steven Schoenfeld, co-author of this article and the Founder and Chief Investment Officer of BlueStar Global Investors LLC, is also the Founder and Publisher of IsraelStrategist.com. He is the Editor of Active Index Investing (Wiley Finance 2004/Toyo-Keizai 2006/China Press 2009). Josh Kaplan is a Research Associate at BlueStar Global Investors LLC. You can read more about the authors and BlueStar Global Investors at BlueStarIndexes.com.